Getting Bank Regulation Back On The Right Track (And Not The Left One)

The question posed at the start of a recent Harvard Business Review article epitomizes what’s wrong with the current government’s approach toward regulating the financial services industry:

With better regulation can we tame the financial markets so they’ll once again perform the social functions that are their responsibility?

My take: It is no more the financial service industry’s responsibility to perform “social functions” than it is Stop N Shop’s or Safeway’s responsibility to feed the masses, or GM’s or Ford’s responsibility to provide means of transportation to people so they can get where they want or need to go. The only “responsibility” financial services firms (even not-for-profit credit unions) have is to deliver profits to their owners.

That’s not to say that you can’t do well by doing good. But we shouldn’t confuse the ends with the means.

The author of the HBR article goes on to say that key to the banks’ success were “their compensation systems, designed to incentivize employees.”  The author claims that these compensation systems “put the larger economy into free fall and destroyed public confidence.”

My take: The huge paychecks that Wall Street and banks have paid out have certainly contributed to the negative publicity that these firms have received. But the statement that the compensation systems put the economy into a free fall is so far from reality that it wouldn’t warrant consideration if hadn’t been issued by a respectable economist.

The reality is that every company in every industry rewards and incents employees for short-term results. How else can you do it? “We sucked wind this year, Ron, but here’s a $500k bonus in the hope that the actions you took this year will produce benefits in 2012 or 2013.” Dream on.

The problem isn’t that we don’t have enough regulation. It’s that we have too much bad regulation, specifically, regulation that isn’t designed properly.

When an industry produces “excess” profits, opportunities are created for new entrants who are able and willing to come into the market and accept lower levels of profit (because their cost structure is lower, or because they’re willing to accept lower current profits with the expectation that they will increase margins later on).

But financial services regulations have created barriers to entry, protecting current players’ margins.

In response, the Democrats’ regulatory stance has been to create regulations that punish the incumbents by reducing fees (and therefore margins), instead of regulation that would help foster competition that would lower those margins, create new wealth, and benefit both consumers and providers.

The examples of wrong-headed regulation can be seen in a number of places.

Take a look at Jeff Marsico’s blog post on deposit regulations, for example, and the perverse and unintended consequences produced. Jeff writes:

Regulators [have] myopically focused on interest expense, to the exclusion of all other costs and offsetting revenue. But to write-off business models that utilize a higher percentage of “hot money” because of higher interest expense denies customers of having choices, limits competition, and further turns the banking model into one homogenized glob.”

Or take a look at what Tom Brown wrote, on, about Gene Ludwig’s (former Controller of the Currency) comments at a recent conference. According to Tom, Ludwig said that:

While regulatory changes are indeed needed, Congress and regulators, in their haste to ‘do something’, aren’t likely to adopt the best solutions. The likely result: more costs to banks and, at the margin, less lending to creditworthy borrowers.”

Another boneheaded idea: Principal forgiveness for the unemployed. If this isn’t an invitation to fraud and rule-skirting, nothing is. Again, from Tom Brown, who quotes from a letter someone wrote to a bank CEO:

Principal forgiveness is an affront to every responsible, non-delinquent borrower in your book of assets…you are rewarding those who bit off more than they could chew, while those who did not take on excess leverage, or who kept their income-to-debt ratios manageable, see no benefit, even as their home equity values have declined.”

At the core of Obama’s regulatory efforts is a fundamentally flawed view of the purpose of regulation.

In a capitalist environment and society, the purpose of regulation should be to ensure the alignment of competing interests and incentives.

Think about that. You might view regulations as something that forces players to do something, or prohibits players from doing something. But a good regulation ensures the alignment of conflicting interests and establishes a win/win situation — or to be more precise, a “win a little less, win a little more” situation, but not a win/lose one.

But Washington’s current approach to regulation is rooted in win/lose, namely: wealth redistribution. This is true whether we’re talking about financial services, health care, or any other area.  It’s fundamentally a win-lose proposition. It isn’t tenable, and it isn’t sustainable.

We need regulation that aligns interests, and creates a win/win situation, for providers and consumers of financial services. We’re not getting it.


5 thoughts on “Getting Bank Regulation Back On The Right Track (And Not The Left One)

  1. You likely have a point about what I’ll call “retail banking” regulation.

    The financial crisis is centered on credit default swaps and CDO’s built from sub-prime and alt-A mortgages. “Wall St.” found that it could originate, package, and sell those mortgages to others, sometimes itself, and through the swaps place bets on mortgages that it had no interest in whatsoever. The managers/traders in the major houses, since the dissolution of Glass-Stegal, no longer partnerships, were not putting their own money at risk in these quite risky, highly leveraged actions.

    Over time they bought their own lie, the lie that sub-prime loans were safe and that they all wouldn’t go south in concert.

    You’ll notice that the often pilloried hedge funds are not at the center of the fraud that conservative Republicans in the Bush administration bailed out via TARP and other similar programs. Its the corporate entities where Main Street banking is now in the same organization as Wall Street banking and the traders of un-regulated exotics are playing with Other People’s Money.

    I believe we need regulation to fix that.

    On the Retail side I think credit card companies have played the roles of “pushers” of credit, seducing people in and then hammering with charges that amount to usury. I’ll fix my own mess on this but they should be prevented from so doing. Caveat Emptor is a weak position on the activities of very well funded and thoroughly lawyered-up unethical dealings.

  2. I guess one could characterize credit card companies as “pushers” of credit, but the reality of economics it that there are two sides: supply and demand. Credit card issuers wouldn’t be successful if there wasn’t a lot of demand. And I would submit that are too many people who have been living beyond their means and asking for credit. Is is the card companies’ “responsibility” to say “stop spending so much”? No. Their responsibility is to offer credit as long as it’s profitable to them to do so. Turns out they may have offered more than they should have. But the irony of it is if they HAD not offered it, some government bureaucrat would have been up in arms that people weren’t getting the credit they were entitled to, and would have created regulations forcing the card issuers to do so.

    There’s an analogous situation on the mortgage side: People bought homes that they couldn’t afford. PERIOD. Did mortgage lenders “seduce” people to buy those homes? No. For all the talk of corporate greed, I think it’s time to recognize that personal greed exists, as well.

    Maybe what we need are regulations that prohibit people from making poor choices. Oh wait, some countries have that already. It’s called socialism. No thanks.

  3. Unfortunately, lawmakers believe that their job is to create new laws in perpetuity…especially if they can demonstrate that they are punishing “evil-doers” in the process. Their role should instead involve a heaping amount of repeal and scrutiny of ineffectve and/or over-reaching existing laws.

    Many banks and credit unions (gasp) deserve at least as much blame as consumers, though, Ron. Bad business decisions are just as unhealthy for our economy as poor consumer choices. Our problem right now is that we have too soft a spot in our hearts for failure. It’s an essential, yet sorely abused, part of capitalism.

    Disclosures don’t prevent poor decisions, and bailouts sure as hell don’t. The threat of failure does. Until we find a way to balance the need for second chances (I firmly believe in them) and the need allow people and businesses to fail in a responsible way, we’ll continue to encourage the inefficient and unsustainable marketplace our legislators in both parties have created.

  4. Supply and demand is only an efficient economic equation when the government doesn’t mess with it.

    What has often been ignored in the case of the current crisis is the role that the government played in building the market for sub-prime loans. HUD quotas placed on the GSEs and mortgage lending institutions boosted demand and initiated the race to the bottom. And the implied federal guarantee of these loans exploded supply.

    Borrowers must bear responsibility for taking loans they can’t repay. Lenders must assume responsibility for building the HUD house of cards into a skyscaper. But it’s the social planners in DC, from FDR to Barney Frank, who should be nailed to the wall for the consequences — unintended and otherwise — of their meddling in free-market capitalism.

  5. Supply and demand, well suited to a discussion of equal players, has little to do with it. Individuals, however smart, are not as capable as nor do they have the legal and financial resources of a major bank. I just took a call from a friend who had worked at a now defunct, small mortgage bank. The attorney for the bankruptcy court went to all who were paid bonuses and threatened litigation to establish that they aided the bankruptcy. In return for not litigating they took 50% of bonuses. Then, they and the accountant billed 85% of what they took in hourly fees. This is but one example. The playing field is not even.

    Additionally, there is universal demand for something that looks free. That is why teaser-rate-based mortgages and unsecured credit offers sell, complete with small print. This is somewhat different from saying its reasonable, much less ethical, to have a system that encourages such offers. Yes, yes, yes each individual is responsible for themselves. This is true of the pusher and the user as well. But the user is weak and the pusher takes advantage.

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